How to Choose a Business Structure: LLC, S Corp, C Corp, or Sole Proprietorship

One of the First Big Decisions You'll Make

If you're starting a business while juggling family responsibilities, you've probably asked yourself: what's the best legal structure for my business?

It's one of the most important decisions you'll make early on. Your structure affects your tax bill, your personal liability, how you pay yourself, and how much paperwork you'll deal with every year.

The good news is that it doesn't have to be overwhelming. There are really only a handful of options, and each one has clear trade-offs.

In this article, I'll walk through sole proprietorships, LLCs, C corporations, and the S corporation election, including a few California-specific costs that catch many new owners off guard.

Sole Proprietorship: Simple, But Exposed

A sole proprietorship is the default. If you start doing business on your own and don't form an entity, you're a sole proprietor.

It's the simplest option. There's no formation filing with the state, and you report your business income and expenses on Schedule C of your personal tax return. You may still need a local business license or a fictitious business name filing.

The Big Downside: No Liability Protection

With a sole proprietorship, there's no legal separation between you and your business. If the business is sued or can't pay its debts, your personal assets, including your home and savings, can be on the line.

You'll also pay self-employment tax of 15.3% on your net earnings, up to the Social Security wage limit, in addition to income tax.

When It Can Make Sense

A sole proprietorship can work for a low-risk side business or while you're testing an idea. Once real money, clients, or employees are involved, most owners outgrow it.

LLC: Liability Protection With Flexibility

A limited liability company, or LLC, is a legal entity formed with your state. Its main purpose is to separate your business from you personally.

If the business is sued or takes on debt, your personal assets are generally protected. LLCs are also flexible to run, with fewer formalities than a corporation.

How an LLC Is Taxed

An LLC is a legal structure, not a tax category. By default, the IRS taxes it based on how many owners it has.

A single-member LLC is treated as a "disregarded entity." For federal income tax, the business income flows straight onto your personal return on Schedule C, just like a sole proprietorship. You get liability protection with relatively simple tax filing.

A multi-member LLC is taxed as a partnership by default. The LLC files a partnership return, and each owner receives a Schedule K-1 showing their share of the income.

In both cases, you'll still owe self-employment tax on your share of the profits. An LLC can also elect to be taxed as a corporation, including as an S corporation, which I'll cover below.

What an LLC Costs in California

If you're in California, brace yourself. Every LLC doing business or organized in California must pay an $800 annual tax to the Franchise Tax Board.

That tax is due whether your business makes a profit, breaks even, or loses money. It's due even if the LLC isn't actively doing business, until you formally cancel it.

California LLCs with total income of $250,000 or more also pay an additional LLC fee on top of the $800, based on gross receipts rather than profit: $900 for total California income of $250,000 to $499,999; $2,500 for $500,000 to $999,999; $6,000 for $1,000,000 to $4,999,999; and $11,790 for $5,000,000 or more.

Other states have their own fees and rules, and many are much lower. Check your state's requirements before you form.

How Business Owners Accidentally Lose Their Liability Protection

Here's something many owners don't realize. Forming an LLC or corporation doesn't guarantee your personal assets are protected.

If you don't treat the business as truly separate from yourself, a court can "pierce the corporate veil" and hold you personally responsible for business debts or judgments.

Common Mistakes That Put You at Risk

The most common mistake is commingling funds. Paying personal expenses from the business account, or business expenses from your personal account, blurs the line between you and the company.

Other warning signs include: not having a separate business bank account; signing contracts in your own name instead of the business's name; leaving the business without enough money to cover its normal obligations; skipping required state filings, like California's annual Statement of Information; and not keeping basic records, like an operating agreement and records of major decisions.

What an LLC Doesn't Protect You From

An LLC also won't shield you from your own actions. If you personally cause harm through negligence or professional mistakes, you can still be held responsible.

And if you personally guarantee a business loan or lease, which lenders and landlords often require, you're on the hook for it regardless of your structure.

That's why the right business insurance is an important layer of protection alongside your entity.

C Corporation: Built for Growth and Outside Investors

A C corporation is a separate taxpayer from its owners. It files its own tax return and pays a flat 21% federal corporate income tax on its profits.

The Downside: Double Taxation

The biggest drawback is double taxation. Profits are taxed once at the corporate level. Then, when the corporation distributes those profits to you as dividends, you pay tax on them again on your personal return.

For many small businesses where the owner wants to take most of the profits home, that second layer of tax makes a C corporation more expensive than the alternatives.

When a C Corporation Makes Sense

A C corporation is often the best fit if you plan to raise venture capital, issue different classes of stock, or eventually go public. Investors typically expect this structure.

It can also make sense if you plan to reinvest most of your profits back into the business rather than pay them out. Certain founders may also qualify for a federal tax break on the sale of qualified small business stock, which can be significant if the company grows.

C corporations come with more formalities, like a board of directors, bylaws, annual meetings, and corporate minutes.

The S Corporation Election: A Tax Choice, Not a Structure

Here's a point that confuses a lot of owners. An S corporation isn't actually a type of business entity. It's a tax election that an eligible LLC or corporation can make with the IRS by filing Form 2553.

Your LLC stays an LLC legally. It's simply taxed differently.

How an S Corp Can Lower Your Taxes

As a sole proprietor or default LLC, you pay 15.3% self-employment tax on your net business profit, up to the Social Security wage limit.

With an S corporation election, you split your income into two parts. You pay yourself a salary through payroll, which is subject to Social Security and Medicare taxes. The remaining profit can be taken as distributions, which aren't subject to those payroll taxes.

That difference is where the savings come from.

A Simplified Example

Say your business earns $150,000 in profit and you pay yourself a reasonable salary of $70,000.

As a default LLC, about $138,500 of that income is subject to Social Security and Medicare tax, for roughly $21,200 in self-employment tax. With an S corp election, only the $70,000 salary is subject to those taxes, for roughly $10,700 in payroll tax.

In this example, the S corp election saves roughly $10,000 a year in payroll taxes before accounting for its extra costs. Your actual savings depend on your profit, your salary, your state, and other parts of your tax return.

The Catch: Reasonable Salary and Extra Costs

The IRS requires S corp owners who work in the business to pay themselves a reasonable salary for the work they do. You can't set your salary at zero and take everything as distributions.

An S corp also costs more to run. You'll need to run payroll, file a separate business tax return, and keep cleaner books. In California, S corporations also pay a 1.5% franchise tax on net income, with an $800 minimum.

Because of those costs, the election usually starts to make sense once your profit is consistently high enough for the tax savings to clearly outweigh the added expense. Your CPA can help you find that point for your situation.

Business Structures Compared

Here's a side-by-side look at how the options stack up.

Personal liability protection: a sole proprietorship offers none, while a single-member LLC, multi-member LLC, C corporation, and an LLC or corporation with an S election all provide it.

Federal tax treatment: a sole proprietorship and a single-member LLC both report on Schedule C of your personal return. A multi-member LLC files a partnership return with a Schedule K-1 to each owner. A C corporation files its own corporate return at the 21% rate. An LLC or corporation with an S election files an S corp return with a K-1 to owners.

Self-employment or payroll tax: sole proprietorships and default LLCs pay it on all net profit (or each owner's share), while C corporations and S elections pay it on salaries only.

Double taxation: only the C corporation faces it, on dividends. The others do not.

California minimum annual tax: a sole proprietorship owes none, while every other structure owes at least $800 a year.

Ongoing complexity: lowest for a sole proprietorship, low for a single-member LLC, moderate for a multi-member LLC, highest for a C corporation, and moderate to high with an S election.

There's no single best structure. The right one depends on your risk, your profit, your growth plans, and how you want to pay yourself.

Choosing the Right Structure for Your Business and Family

Your business structure affects your family's financial security, your tax bill, and how your business can grow. It's not a decision to make based on a single article.

A few questions can help guide the conversation: How much risk does your business carry, and could a lawsuit or debt reach your personal assets? How much profit do you expect, and how consistent will it be? Do you plan to take most of the profit home, or reinvest it? Will you bring on partners or outside investors?

Your structure can also change as your business grows. Many owners start as a single-member LLC and add the S corp election once profits rise.

Build the Right Team

Working with a CPA, a business attorney, and a financial planner can help you make an informed choice.

A CPA can run the tax numbers. An attorney can set up the entity and protect your liability shield. A financial planner can make sure the structure fits with the rest of your family's financial picture, from retirement plans to how you pay yourself.

Source: California Franchise Tax Board, "Limited Liability Company."

Advisory services are offered through Daley Financial Planning, a DBA of Forefront Advisor Network. This article is for educational purposes only and is not investment, tax, or legal advice. Entity and tax rules vary by state and change over time; consult a qualified CPA and attorney about your situation before choosing or changing a business structure.